Take A Prosperous Ride On The Banking Sector

It does not happen very often that you get an opportunity to really make a killing in the stock market.

Now, a special situation is playing out - a combination of fundamental and technical indicators are lining up perfectly in a great set-up that enables us to benefit from this opportunity in this specific industry. I am referring to the banking industry and to the forthcoming macro events. I believe the banking sector will reap fantastic rewards in the next couple of years due to the following reasons:

Weakness of the U.S dollar: Although pundits disagree on the rate of the slowdown in the U.S or whether things have already turned the corner, there is one thing almost no one disagrees on. The massive printing of money will depreciate the value of all paper currencies. Buffett, in his recent letter to shareholders, stated that "although in God we trust, the hand that operates the printing machines is all too human". This, in turn, will lead to a steady appreciation of prices. You can also call it a gradual spike of inflation if you wish. The immediate effect of this will be an increase in the prices of assets. Since the balance sheets of banks hold a tremendous amount of assets, they will be the first ones to benefit from this effect. Not only that, but banks are highly leveraged, which means that every marginal increase in the prices of assets will be magnified.

Cost of Capital: Money has never been cheaper. Investors are piling into bonds like sheep and are satisfied with ridiculously low yields. Take Coca Cola (NYSE:KO), for example, which was able to raise its 3 year debt by paying a measly 0.75% per annum. That is how desperate for yield investors really are today. By maintaining an artificially low interest rate, the banking industry can borrow money from unsuspecting CD savers and then reinvest the proceeds for much higher yields.

Trading Profits: We are living in an era with exceptionally high volatility. High volatility often translates to trading profits when implemented successfully by seasoned traders. Bank of America, in reporting first quarter 2012 financial results, stated that sales and trading revenue, excluding DVA, was $5.2 billion in the first quarter of 2012, compared to $2.0 billion in the fourth quarter of 2011 and $5.0 billion in the first quarter of 2011. This trend is likely to continue.

Great Defense. The Fed has fully digested the fact that all banks are 'must exist' entities. They do not have the privilege of allowing any major bank to collapse, dragging the U.S back into recession specifically at this fragile and gradual recovery. Banks nowadays enjoy the fabulous status of 'sovereign' entities.

It Is an Unloved Sector: We always like to buy a sector when it is hated or feared. When both emotions are in play, that is even better. As of now, the banking sector has lagged the overall market by 15% over the course of the past 5 years. People are wary of banks after the 2008 events and they are scared to put their money back into this 'horrifying' sector once again.

So which bank should we pick?

Every once in a while, a certain stock is positioned to have outsized gains. We will try and base our investment decision on some valuation metrics. Look at the table below:

As you can see, Bank of America is the cheapest of them all in terms of book value. Eventually, when fears will fade, all banks will trade at or above their book value. Nothing else makes sense.

A contrarian view

Not everyone agrees with me of course. Some experts claim that banks will be forced to write down the value of their assets and that they will not be able to reap the rewards of a low interest rate environment. I disagree.

Technical front

BofA has had a great run in price this year but this is no reason to be suspicious of it. It now retreated to $8 after barely touching the $10 area. That is a retreat of almost 20%. The stock has strong support at $7.6 which it tested for several times and did not violate it downwards.

My Recommendation

Buy shares of BAC up to the price of $10. place a stop loss at $7. It is fairly difficult to determine when to take profits at this early stage. Alternatively, you can buy call options at the $10 strike due to expire on January 13th, 2013. They are not expensive and the spreads are very tight.

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